Am opening this thread to explore the possibility of USC-R2I investing in Indian debt mutual funds without incurring high PFIC taxes imposed by US.
USC-R2I have a need to invest their fixed income portion of AAP in Indian debt market. From an Indian tax point of view, Indian debt mutual funds offer several tax advantages. However Indian mutual funds are PFIC per US tax law, and USC are subject to US tax law even if living in India.
In the past, I have opened a thread on Indian deep discount or zero coupon bonds to see if it can be a reasonable avenue for deployment of fixed income AAP portion of USC-R2I. India zero coupon bonds offer good Indian tax advantages and do not suffer from PFIC problems - however the market for them is not yet developed for access by retail investors.
In this thread, I want to explore another idea, which involves investing in the dividend option of India debt mutual funds which distribute almost all yearly income as dividends every year, and where dividend distribution does not fluctuate wildly over successive years. Perhaps such mutual funds can be identified by looking at Indian mutual fund web sites. Tax consequences are discussed below:
India Tax Consquences
Fund has to pay dividend distribution tax of about 14% to Govt which is a cost investor pays. However 14% is lower than 30%+ which is the marginal India tax rate for many USC-R2I. Dividends are not taxable by GOI in the hands of the investor. So by paying 14% tax on dividends (via the fund), investor has washed his hands off all GOI tax liability on the dividend.
US PFIC Tax Consequences
First, the 14% tax paid to GOI by fund is not likely eligible for any foreign tax credit from IRS since the same was paid by fund not the investor.
The Indian mutual fund is PFIC. The tax consequences are:
If a PFIC does not agree to be subject to the jurisdiction of the SEC and does not provide the IRS with the annual information the IRS requires for a QEF election, then the shareholders of the PFIC are subject to
(1) ordinary income tax on any current distributions from the PFIC, (2) distributions and dispositions of fund shares deemed to be from prior years earnings of the PFIC are taxed at the highest rate for ordinary income in each prior year and (3) an interest charge on the deferred distribution.
Distributions in the first of year of a PFIC are treated as ordinary income. Future distributions are also treated as ordinary income to the extent that the distributions are no more than 125% of the average distributions for the previous three (or fewer) years. Thus, planned distributions can be used to minimize the tax on distributions of accumulated income. ------------------
If a fund distributes all of its income as dividends yearly, and dividends do not fluctuate wildly across years (no more than 1.25 average dividends over 3 years), then the entire dividend will qualify to be treated as ordinary income for US tax purposes. The marginal tax rate for US tax purposes is likely to be low for USC-R2I.
At some point units will be sold. At that time if NAV of the fund is close to NAV at the time of purchase, gain on disposition (and hence PFIC taxes on the same) will be low. In any event taxes cannot exceed amount of gain (need to confirm this from authoritative source).
Hi Bobus, Sorry if it sounds a bit obvious. If someone is planning to R2I in say 4-5 years and prepared to invest with atleast that kind of a Time-Horizon in mind. Assuming this person does not want to repatriate the investments made in MFs in India then do they still come under the purview of US PSIC just because they happen to be US Residents now. What I am presuming is that they will invest in GROWTH SCHEME of Funds and will hold them till R2I [So no dividends and No Capital Gains ...] True there may be people who want to invest in India and still be able to repatriate the proceeds to the US but keeping them aside for a moment is it not possible to just set aside some % of your Portfolio to Indian Mutual Funds when they have the idea of R2I in a finite period of time. Regards Venkat
(a) USC living anywhere including India (b) GC holder living anywhere including India (c) Someone living in the US and meeting the substantial presence test e.g. H1B via holders (d) Spouse of any of the above who elects to file as US resident.
If someone is a US resident for tax purposes at the time of receipt of dividends or at the time of sale (disposition) of Indian mutual funds, then the person will be subject to PFIC rules. This means that USC-R2I is subject to PFIC rules unless USC is relinquished even after R2I. It is for such people that this thread was created.
Someone on H1B will become NRA (non resident alien) after R2I and as NRA his/her non-US source income is not subject to US tax. So of a H1B buys Indian mutual fund growth option (no dividends) units, holds them on (no sale) until he becomes NRA and then sells them, no tax event has occured when the person was US resident and there is no tax due to IRS. However, a proposed ruling that was originally issued in 1992 and is yet to be made final (effective) states that a PFIC stock will be deemed to be sold (even if not actually sold) on the last day of US residency. If this proposed ruling becomes effective, the escape route for H1B above will not work.
--------------- Know of any closed end Indian debt funds that trade like ETFs?
Nifty BeES391.6669389.85210.47% Junior BeES69.245969.2643-0.03% Bank BeES 585.6375 587.5836-0.33% Liquid BeES 1000 10000.00% Derivative Fund (D) 20-12-061022.8627141021.17420.17% Derivative Fund (G) 20-12-06 1134.736398 1132.86320.17% SCF - Class A 20-12-06 124.4029123.553 0.69% SCF - Class B 20-12-06 126.8412126.04970.63%
Prudential ICICI have an Exchange Traded Fund but that is an Equity based fund [based on the BSE Sensex]
------------- So far I have proposed two ideas for USC-R2I in so far as investing fixed income portion of their AAP in Indian mutual funds is concerned:
(a) Invest in debt funds dividend option where all income is distributed yearly and dividend distribution in any year is within 1.25 times 3 year moving average.
(b) Look if there are any Indian debt funds that trade like ETFs.
Beyond (a) and (b), here is a third idea for those who can be careful and can fill Form 8621 (PFIC tax form).
Step 1: Invest in growth option of Indian debt mutual fund (e.g. PruICICI MIP Cumulative) on say Dec 27th (important that investment be made toward end of US tax year) of Year 1. Check zero entry and exit loads for investment duration of 1 year.
Step 2: Redeem (sell) all units on Dec 28th of next year (Year 2) and buy back the same units the same day. Need to check from authortative source if sale on Dec 27th will qualify as sale of long term cap asset or if sale has to occur on Dec 28th or later for the cap gain to qualify as LTCG.
India tax consequences: Cap gain on sale of debt mutual funds shares that qualify as long term capital asset is subject to tax @10% without indexation benefit or 20% with inflation indexation. Max tax is 10%.
US tax consequences: The cap gain will have to allocated ratably to the entire holding period of 365/366 days. Most of the holding period is in Year 2 (current year when disposition occurs) while Year 1 (prior year) has a holding period of just a few days. Cap gain allocated to Year 2 will be taxed as ordinary income. It is only cap gain that is allocated to Year 1 that will be subject to tax at high rate and interest - however the cap gain allocated to Year 1 will be small since the holding period in Year 1 was small.
The above are still at development/exploration stage. Need to check if there any gotchas, and if no major gotchas, they need to be fine tuned.
To the best of my knowledge Liquid BeES is a good ETF which invests primarily in Debt and Money-Market Securities. Note however that the NAV of this scheme is Rs 1000 and minimum lot size is 25. So you are talking about a minimum investment amount of Rs 25000 at a time.
Will update this thread if find any other funds.
In case you are not aware the Indian Equity Market is bigger than the debt market and the equities are so much hyped these days that some has even forgotten that a debt market exists !!. I understand in the US the Debt Market is bigger than the equity market.
Most people in India who invest in Mutual Funds do not even consider debt funds as an option, it is either balanced funds [mix of debt and equity] OR Diversified Equity Funds.
Thanks, will check Liquid BeES - the lot size shd not be an issue.
While equity market capitalization is more than the value of corporate debt that is traded in India, I recall reading a few months ago that in so far as investment in Indian mutual funds is concerned, the debt mutual fund investment is much higher than that in equity mutual funds. Yes, there is hype associated with Indian equity performance and some fall for it, but most still prefer fixed income avenues - that is my understanding.
The returns are low. I want to identify a rupee fixed income investment avenue for USC-R2I that offers better after-tax return than bank fixed deposits.
For USC-R2I fixed income allocation in India, to get better after-tax returns than laddered bank FDs, keeping in view of IRS PFIC tax rules, so far four options have been identified:
(i) Zero coupon bonds - problem is that market is not yet developed for retail investor access - further zero coupon bonds are inherently long term and carry interest rate risk.
(ii) Investment in dividend option of India debt mutual funds that pay out all income as dividends regularly and where dividend distribution in any year is within 1.25 times 3 year moving average. Problems are that returns of such funds seem low and more importantly dividend distribution may sometimes be in excess of 1.25 times 3 year moving average in which case PFIC taxes are attracted on the excess.
(iii) Investment in Indian debt ETFs - one only one such fund Liquid BeEs has been identified and return is poor - if better ones are identified than mark-to-market election can be used for US tax return purposes to avoid high PFIC taxes.
(iv) Investment toward end of calendar year in India growth option debt mutual fund and liquidation promptly one year and 1 day later (to qualify as long term cap asset for India tax purposes) - will need to be prompt, and be willing to complete Form 8621 for US tax purposes - this shd not be difficult. Because of the requirement that holding period needs to be 1 year + 1 day to qualify for LTCG per India tax rules, reinvestment date will get shifted over years toward end of calendar year and in some years the date of liquidation/reinvestment will be a holiday. When reinvestment/liquidation day spills into next calendar year, will need to deploy in bank FD for about 11 months and then restart strategy. So far this is the avenue that seems most promising. Will expand on this option in later posts.
Say pretax return from growth debt mutual fund is 8% for 1 year. Say investment was made on Dec 14th of Year 1 and liquidated on Dec 15th (and reinvested same day) of Year 2. Assume marginal US rate is zero. Assume investment amount is 50 lac rupees.
Gross return is 8% of 50 lacs i.e. 4 lacs.
India tax will be 10% (India LTCG rate on debt mutual fund) on the 8% = 0.8% 0.8% of 50 lacs is 40K rupees.
US Tax
Holding period in Year 1 is 18 days (Dec 14th to Dec 31st) while holding period in Year 2 is 348 days (Jan 1 to Dec 14th) . Total holding period is 348+18 = 366 days
Gain of 8% allocated to Year 1 is 18/366 (round it off to 1/20 or 0.05) of 8% = 0.4%. Remaining gain is allocated to Year 2 and is taxed at marginal tax rate which is zero (assumption above).
0.4% of 50 lacs is 20K rupees.
PFIC tax on the gain (excess distribution) allocated to Year 1 is at highest marginal tax rate that was prevalent in Year 1 which is currently 35%. Add underpayment interest for 1 year on the this tax. Underpayment interest is 8% now. So payment due to IRS will be:
0.4% * 0.35 * 1.08 = 0.1512%
0.1512% of 50 lacs is 7,560 rupees (can also be calculated as 20K rupees * 0.35 * 1.08)
Assume no credit is taken from IRS for the 10% tax on gain paid to GOI.
